CONTRIBUTED ARTICLE: By Stephen Miller, advisor, GSFM
When it comes to the Covid-19 crisis, if we have learnt anything amid the plethora of commentary from an army of ‘experts’ across a plurality of disciplines, it is just how much we don’t know.
To paraphrase former US defence secretary, Donald Rumsfeld, not only are there a lot of ‘known unknowns’ but by definition incalculable ‘unknown unknowns’.
Economic and financial developments, and more importantly economic and financial forecasts, should be understood in that context. Put simply, the current circumstance is one for which there is little precedent and forecasting, which is fraught at the best of times, and especially so now.
On the economic consequences, it is safe to say that the ‘base case’ is probably the worst we have confronted since the Great Depression. But the distribution of possible outcomes is immensely large, and, in my view, skewed to the downside.
In the Australian context, that much has been asserted by our most senior econocrats, including RBA Governor Philip Lowe and Treasury Secretary Steven Kennedy. They have both articulated scenarios encompassing falls in GDP of greater than 10% and an unemployment rate running well into double digits.
In fact, the impact may be bigger on Australia than other developed economies.
Australia is a medium-sized open economy dependent on a smoothly functioning international trading environment and was already under some stress before the onset of the crisis. To date, population growth (aided by an influx of overseas students and tourists) has underpinned Australia’s enviable growth record, but population growth is set take a considerable hit and recovery from this is likely to be slow. Offsetting this may be the recent realisation of Australia’s relative success in preventing the spread of Covid-19.)
Globally, however, financial asset prices seem to imply that investors are quite sanguine about the outlook. Markets are implying that the bounce back will be well under way by the fourth quarter of 2020 and will be ‘V’ shaped rather than a ‘bath-tub U’ or, worse still, an ‘L’ shape.
In the US, the S&P500 is some 28% off its lows of 23 March and ‘only’ 15% shy of its peak in February. It is currently trading at around levels seen in early June 2019, a time when some analysts were questioning whether the market then was ‘stretched’.
In Australia the S&P/ASX200 is about 20% off its lows and still some 25% from its February peak, reflecting, inter alia, the high weighting of bank stocks in the Australian market.
Financial markets are drawing an extraordinary degree of comfort from the stimulus packages from governments and central banks. These packages go well beyond anything contemplated during the GFC. Both the Fed and the ECB are buying private sector debt (including ‘junk’ bonds) to support those markets, while locally the RBA has undertaken quantitative easing (QE) measures.
On the fiscal side, there have been extraordinarily large packages put together, including Australia’s at a little over 10% of GDP.
But are markets drawing too much comfort?
Arguably risks were weighted to the downside before the Covid-19 crisis. Not only were trade tensions already elevated, but global politics were dysfunctional. The US was characterised by ‘gridlock’ and a polarising presidential campaign. In Germany, Angela Merkel was in government but not power, and China had a Hong Kong problem.
Geopolitical tensions were rising (witness US/China tensions, a cyber ‘Cold War’ and ongoing turmoil in the Middle East). Governments were wrestling with deep-seated structural issues such as climate change, inequality and ‘oligopolisation’.
And this at a time when monetary policy, as we conventionally understood it, was exhausted, and the efficacy of any future stimulus was doubtful. Similar doubts attach to the monetary policy innovations instituted since the onset of the crisis.
Investors must also contemplate potential longer-term pitfalls relating to exit strategies from extraordinary stimulus. What, for instance, are the consequences of Fed and ECB purchases of private sector debt?
It was a build-up in non-financial leverage (i.e. debt) that tipped the world into the GFC. In the period since, not only has corporate debt increased but its quality has deteriorated, and the stakes just got higher with Fed and ECB purchases of private debt. The ‘moral hazard’ issues attaching to those measures loom large.
There are misgivings too about the potential for monetary financing of budget deficits—a type of ‘modern monetary theory’ in its most extreme form—and the potential longer-term inflationary, or perhaps stagflationary, consequences of such measures.
Caution is warranted and will be for some time. Despite the signs that authorities are on top of the spread of Covid-19, the ‘unknowns’ loom large, particularly in the post-lockdown period and with the negative economic consequences potentially underrated.
The first principle of investing is diversification, and now is a good time to remind ourselves of the virtues of that principle.
First appeared in Firstlinks.